Fed Still Caught in a Trap Comstock Partners, Inc. Thursday, June 22, 2006
The Fed remains caught in a trap between rising inflation and indications of an impending softer economy. Higher inflation rates are indicated by core PPI, core CPI, Philly Fed manufacturing prices and comments in the recent Beige Book. Year over year core CPI was up 2.3% in May, above the Fed’s 1-to-2% comfort zone. Moreover, if the core CPI on a month-to-month basis is up 0.2% in June, July and August, the year-over-year rate will be 2.3% in June and 2.5% in both July and August, the highest since January 1995. Since these numbers would likely send out alarm bells in the financial world, the Fed has already strongly indicated that it would hike rates by another 25 basis points at next week’s meeting, with the following meeting in August remaining subject to the usual “incoming data”.
The Fed’s problem is that even before any additional rate hikes, a number of important indicators already point to an impending economic slowdown with the potential for a hard landing. The Fed has already raised rates by 400 basis points, and a large number of nations throughout the world are in the process of tightening as well. Other harbingers of softness ahead are high energy prices, a negative yield curve, higher long-term bond rates, declining leading indicators, slow disposable personal income (DPI) growth, tepid consumer spending, lower money supply growth and a weakening housing picture.
Housing weakness is reflected in the lowest housing affordability rate in 15 years, the lowest NAHB index in 12 years, soaring inventories of both new and existing homes and reports of the leading home builders. The year-over-year increase in real DPI was only 1.1% in May, the lowest since 1994, and the January through May annualized growth was virtually unchanged. It is therefore no surprise that, according to the Michigan survey, consumer income expectations are the lowest since 1992. With today’s report of a drop the Conference Board’s leading indicators index for May, the annualized six-month rate of change is now -0.4%. Of the last 14 times the annualized six-month rate of change dropped below zero, 9 were followed by recessions and 11 by bear markets.
The Fed recognizes that inflation is a lagging indicator and that the economy is likely to weaken. It therefore would like to pause and wait for incoming data. However, when Bernanke mentioned the possibility of a pause, inflation expectations soared, particularly in view of his 2003 remarks about throwing money out of helicopters. The new chairman and other Fed governors were therefore forced to emphasize their deep concern about inflation in a series of speeches and interviews. Having been forced to show their inflation-fighting credentials the Fed now has to carry through with at least one more rate increase.
The problem is that after allowing a late 1990s stock market bubble and a 2003-2006 housing bubble, the Fed has basically lost control. It feels the necessity to fight inflation until further signs of economic softening show up, and by that time it is too late to avoid a likely recession. In our view the latest market correction is the first leg down in a new cyclical bear market that is a continuation of the secular bear market that started in early 2000. The decline has the potential to be particularly dangerous in view of the massive consumer debt buildup, record trade deficit and the many trillions of dollars of outstanding derivatives.
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